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The Ground Floor

What Will End REITs' Rally?
A Technical Answer

By

Barry Vinocur

Updated Aug. 7, 2000 12:01 am ET / Original Sept. 15, 2019 9:32 am ET

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A fter back-to-back years of negative returns, real-estate investment trusts are having their best year since 1996. The widely followed Morgan Stanley REIT Index has chalked up a total return of some 25% so far, outperforming broader market benchmarks -- most notably the formerly red-hot, technology-heavy Nasdaq.

Helping to fuel the run-up are second-quarter earnings surprises from a long list of companies. Heading into last week, REITs had delivered growth in funds from operations -- the REIT equivalent of earnings -- of 11.5%, well ahead of the expected 9.2% FFO growth, according to analyst Jonathan Litt of Salomon Smith Barney. The sector's performance has brought a step-up in the flow of money into the sector. According to AMG Data Services, in the most recent week, real-estate mutual funds enjoyed the largest fund inflow in recent memory, totaling $146.5 million.

Are those investors arriving at the party too late?

To answer that question, the newsletter Realty Stock Review compared recent valuation measures with the levels at the end of 1997, just before the start of the REIT stocks' two-year slump. Based on that review, it's tough to argue that REITs have become overvalued today.

For instance, at the end of 1997, the average property-owning REIT followed by the newsletter was trading at just over a 20% premium to consensus estimates of its net asset value. As of July 28 of this year, the average REIT was changing hands at a 9% discount to estimated NAV.

The dividend yield on more than 120 REITs tracked by Realty Stock Review at the end of 1997 was 6.3%; as of July 28, it was 8.5%.

Most notably, REIT multiples are well below their late 1997 levels. As of July 28, the universe of REITs and non-REIT real-estate operating companies tracked by the newsletter were trading at 8.6 times consensus estimates of next year's adjusted FFO. At the end of 1997, the stocks were trading at 12.8 times.

What could put an end to the REIT rally? At the top of nearly everyone's list is a sharp and sustained run-up in tech stocks; studies indicate that Nasdaq shares and property stocks tend to move in opposing directions.

In a recent dispatch to clients, analyst Lou Taylor of Prudential Securities noted that since January 1, the Morgan Stanley index has had a negative correlation with the Nasdaq Composite. He also observed: (1) the Nasdaq's peak nearly matched the trough for the Morgan Stanley; (2) even as the Nasdaq rallied in June, so did the Morgan Stanley, suggesting little conviction in the Nasdaq rally; and (3) when the the Nasdaq turned down in early July, REITs went almost straight up.

"So for those wondering when the REIT rally will end, we would look to Nasdaq," Taylor wrote. "If it starts to rally, we think investors are going to take money out of REITs."

T he sad saga at
Burnham Pacific Properties
may finally be nearing its end. As we reported in this space on June 19, after rejecting out-of-hand a $13-a-share bid -- later raised to $13.50 -- from the Schottenstein Group of Columbus, Ohio, last year, the San Diego-based shopping-center REIT hired
Goldman Sachs
to advise it on alternatives, including a possible sale. Burnham has seen its operating performance deteriorate over the past year, and some analysts now value the company at only $6 a share or so.

Early last week, according to sources close to the process, Coventry Partners, a joint venture of
Developers Diversified Realty
and an arm of
Prudential Insurance Co.
, submitted a revised bid for Burnham of $5.46 a share; it had previously offered $8 a share, but that bid carried certain contingencies that now apparently have been removed. The current offer could be fattened by as much as 50 cents a share if certain conditions are met, say the sources. Goldman Sachs is expected to recommend that Burnham's board accept the offer.

Late last week, however, a complication arose. The Coventry bid apparently triggers an overlooked provision in a late 1997 agreement between Burnham and two funds, Blackacre Capital and Westbrook Real Estate Partners, that had invested $120 million in the REIT. The provision requires Burnham, in the event of a noncontingent bid, to repay the two investment funds or to cease paying its dividend. Because the highly leveraged Burnham's current dividends already exceed cash flow, it's unlikely the company could raise the money to pay off the funds. That leaves Burnham with only three unattractive options: It could ask Coventry to withdraw its bid; it could try to negotiate a side deal with Blackacre and Westbrook, an effort likely to fail; or it could suspend its dividend.

Last Thursday morning one investor dumped a 517,600-share block of Burnham stock at 5 3/4.

Spreads Tighten as Loan Volume Slows

A shortage of new loans on commercial properties has put a modest squeeze on interest rates on individual mortgages and on commercial mortgage-backed securities. According to the Barron's /John B. Levy & Co. monthly survey of more than 30 institutional mortgage investors, spreads --the gap between rates on such instruments and rates on comparable Treasury securities -- have tightened over the past 30 days. CMBS spreads at the triple-A level narrowed by a respectable 0.05 of a percentage point.

Among life insurers, a major source of commercial-mortgage money, lendable funds are in line with loan demand. To be sure, the funds are concentrated on short-term lending -- three to five years -- and there is a noticeable shortage of money for loans of 10 years and longer. For mortgages that institutions clearly view as triple-A -- those for 50% of a property's value or less -- spreads can be quite thin. Some insurers and pension funds are willing to offer loans with spreads in the 1.6-percentage-point range, which is comparable to triple-A-rated public CMBS. The institutions argue that their whole loans are at least as secure as the publicly traded versions. Indeed, in the first six months of this year, whole loans generated a decent total return of 5.10%, according to the Giliberto-Levy Commercial Mortgage Performance Index. Although they outperformed investment-grade CMBS, the whole loans lagged behind the high-yield CMBS, which posted a nifty 7.32% return. Meanwhile, aggregate credit losses continue to run at their lowest levels in two decades. But shopping centers did show a small rise in losses.

The lack of loan originations has reduced the volume of new securitizations. Nowhere is that more apparent than in a new securitization being offered this week by GMAC Commercial Mortgage,
Deutsche Bank
and
Goldman Sachs
. Even though the offering combines collateral from three heavyweight originators, it still weighs in at just under $700 million. In late July,
Credit Suisse First Boston
sold a $1.1 billion fixed-rate securitization, which by all accounts traded well. Analysts noted that there was heavy competition for the tranches rated double-A and lower, with especially fierce combat in the below-investment-grade tranches rated double-B, priced at a spread of 5.2 percentage points, and double-B-plus, priced at 4.75 percentage points. This surprising strength comes at a time when Moody's is noting a continuing decline in the credit quality of U.S. corporations, with downgrades swamping upgrades by a margin of 2-to-1 for the year's first six months.

In what could be a first, Deutsche Bank is planning to securitize $200 million of its loans that had previously been removed as collateral from other securitizations at the behest of buyers of the riskiest tranche. Because those loans are viewed as tainted, spreads are expected to be unusually wide. Deutsche Bank is rumored to be actively seeking other investment banks to join them in this endeavor. Executives there confirm that they are doing market research on this concept.

-John B. Levy

JOHN B.LEVY is president of John B. Levy & Co. in Richmond, Virginia. Website: www.jblevyco.com

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